Why Predicting China’s Economic Growth is So Hard

Signs of slowing real estate investment, shrinking manufacturing output and a shift to pro-growth monetary policy have China economists revising their forecasts for 2012. But predicting the outlook for growth in any country is fraught with difficulty. When it comes to China, the problems are compounded.

Rapid changes in the structure of the economy, absence of long-run historical data on some key variables and no data at all on others mean there is more art than science in forecasting China’s growth, and a fair amount of guesswork tossed in along the way.

As Bill Adams, senior economist at PNC, says: “the underlying assumption of most models is that relationships in the future will be the same as relationships in the past. In China that is often not the case.”

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Forecasts are underpinned by estimates of the potential growth rate of the economy, and it is here that the uncertainties start. Potential growth is determined by limits on the availability of labor, capital, and how effectively the two can be put together.

In the U.S. and major European economies, all those variables are known, or estimable with some degree of accuracy. In China, they are not. The number of rural workers waiting to make the trek from farm to factory, the size of the capital stock and the extent of productivity growth are all subject to considerable uncertainty.

What everyone agrees on is that China’s potential growth rate is slowing. But with so much disagreement on the basics of labor force and capital stock, predicting how far and how fast it will slow is no easy task. In practice, many economists simply look at the current growth rate and assume a gradual slowdown over the next decade.

With estimates on the potential growth rate as the basis, forecasts for growth in the year or two ahead are essentially a calculation of how much changes in demand will push actual growth above or below potential.

To frame their thinking, economists use the definition of gross domestic product as the sum of consumption, investment and net exports.

Louis Kuijs, a former International Monetary Fund economist now at the Fung Global Institute, explains that calculating the contribution of each component to gross domestic product relies on a set of equations that model how key variables affect behavior.

To forecast household consumption, for example, Mr. Kuijs would consider the impact of changes in wages, wealth levels and confidence on spending decisions. In China, that is no easy task.

Take the relationship between exports and consumption. The crisis in Europe will surely affect China’s export sector in 2012, and that will affect employment, wages, and household consumption. But how much? China doesn’t publish meaningful data on unemployment and data on wages are little better. Estimating the impact of a hit to exports on consumption relies as much on judgment as on hard data.

For investment, the amount of capital spending by both business and government is subject to huge uncertainty. Animal spirits are a decisive factor affecting business investment. If firms think growth is surging, they will stump up for new plant and equipment. If they think growth is slowing, investment can drop to zero.

Those animal spirits make forecasting business investment tough anywhere in the world. But in the U.S. and Europe there are decades of data to show how businesses typically respond to changes in the economic cycle. In China, three decades of almost unbroken growth and rapid changes in the structure of industry mean it’s difficult to predict.

Adding to the confusion, if business investment falls sharply – as it did in 2009 – there’s every chance the government will step up to the plate. That decision can have a huge impact. In 2009, it was massive public infrastructure investment that saved the day. But there’s no way that looking at historical trends would allow economists to forecast it.

For exports, forecasting the contribution to growth in mature economies is straightforward. An estimate of demand in trading partners, combined with change in competitiveness, yields an accurate result. But for countries still emerging onto the world stage, like China, this approach doesn’t work so well.

Take 2012. A recession in Europe would certainly dent demand in China’s trade partners, and rising wages will eat into competitiveness. But if China continues to take a bigger share of global markets, that will cushion the blow from fading demand and competitiveness. The overall impact is difficult to predict.

With so much uncertainty about key numbers and relationships, economists have moved beyond using a pure modeling approach to generate forecasts. Judgment and intuition are in the mix as well, and play a larger role in China than they would do in forecasting growth in the U.S. or Europe.

So should we treat China forecasts with a greater degree of skepticism than we do those for mature economies? According to Mr. Kuijs, the answer is yes and no: “On the one hand, the uncertainty about the numbers is greater” he said. “On the other, China’s government feels very strongly about growth and tends to have the policy leeway to target it. So if growth weakens strongly the government can be relied on to provide stimulus to get growth back up.”

The markets are counting on the economists to get their growth forecasts right. The economists are counting on the government to help them out.

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